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Every Tuesday I answer a question about expatriation from a list subscriber. I also send other emails on this list from time to time, but only about expatriation-related topics.

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Question

This week’s question came from reader Hank, who signed up for the International Tax Lunch mailing list. He suggested a number of topics, one of which was this:

Handling of an IRA still held in United States after becoming non-resident.

This week, we will look at what happens to an IRA after its owner expatriates. In order to keep this email relatively short, I will only talk about covered expatriates.

Answer

Continuing to leave an IRA in the United States after expatriation is a poor strategy. The IRA is subject to US estate tax, and the income tax consequences can be problematic.

A covered expatriate would be wise to cash out an IRA immediately after expatriation.

Why? Income tax

Here is how a covered expatriate’s IRA will be taxed.

Income tax on expatriation-date value

A covered expatriate pays income tax on the value of an IRA at the time of expatriation. The exit tax rules treat a covered expatriate as if there is a full distribution of the entire IRA on the day before expatriation. I.R.C. §877A(e)(1)(A).

There is no early distribution tax imposed on this “pretend” distribution. I.R.C. §877A(e)(1)(B).

No further income tax on the expatriation-date value

Since the entire value of the IRA has been fully taxed, a covered expatriate can immediately close the IRA and take the expatriation-date value out of the United States without any further tax:

The deemed distribution at the time of expatriation is treated as an “investment in the contract” — roughly equivalent to the concept of basis in an asset. Notice 2009-85, §6; 2009-2 C.B. 598. The return of this amount to you is not included in gross income. Notice 87-16, 1987-1 C.B. 446.

There is no early distribution tax. The 10% early distribution tax applies only to amount included in gross income, and the return of investment is not included in gross income. I.R.C. §72(t)(1).

Growth after expatriation: taxed at 30%

If the covered expatriate does not immediately close the IRA, it will continue to be treated as an IRA after expatriation: account growth is not taxed, and tax is imposed when a distribution is made.

The covered expatriate who waits until after expatriation to take a distribution from the IRA will have the following tax consequences:

Every distribution to the covered expatriate is pro-rated between return of investment and growth. I.R.C. §72; Notice 87-16, §III; 1987-1 C.B. 446.

The IRA administrator withholds 30% of every payment. I.R.C. §1441(a). Since some of the distribution to the covered expatriate is nontaxable (return of investment), this means that too much tax will be withheld.

Treaties may or may not alleviate the problem. A number of income tax treaties give the United States the right to tax former citizens for a period of time after expatriation. The effectiveness of these treaty clauses is unknown (they were written to apply the now-extinct rules of I.R.C. §877) but the fact is that these provisions exist, creating problems.

Possible double taxation

If the covered expatriate lives in a country with an income tax, there may be a double taxation of a later distribution from the IRA. This is because the covered expatriate’s home country is:

likely to include the later real IRA distribution in taxable income for home country taxation purposes; and

likely to deny a foreign tax credit for the earlier U.S. income tax paid on the pretend IRA distribution triggered by the exit tax rules.

Foreign tax credit is usually given only when there is a taxable transaction. The change in U.S. tax status from resident to nonresident is simply not a taxable transaction as far as the home country is concerned.

What this means is that the United States will tax the value of the IRA when the IRA owner expatriates, but the covered expatriate’s home country will not tax it — because it is not a real IRA distribution and thus is not taxable under home country tax laws.

And it means that the United States will not tax the later distribution of funds from the IRA (because under U.S. law the money was already taxed) but the home country will tax the later distribution.

Foreign tax credits are built to solve problems like this, but from the home country’s perspective, the exit tax paid to the United States will look like a noncreditable foreign income tax — something that the home country will not let the covered expatriate carry forward to later years when the actual distribution occurs.

This is a murky, murky area at the moment. Foreign countries are just now starting to come to grips with the problem of how to deal with the U.S. exit tax. The results here can vary depending on the application of income tax treaties. So the moral of the story is to tread carefully.

The better solution for a covered expatriate is to close out the IRA and distribute everything shortly after expatriation. In that way, the U.S. tax on the pretend distribution and the home country tax on the real distribution will happen in the same year. You can likely claim the foreign tax credit because these events happened so close in time. Not that we are suggesting anything but full and utter fealty and unwaivering faithfulness to your home country tax law. Far from it.

Or, if the covered expatriate is over 59.5 years old, simply take a real distribution from the IRA before expatriation. There will be no early distribution penalty, and the distribution is classically taxable in the USA and foreign tax credits can be taken in the home country.

Why? Estate tax

A non-U.S. citizen who does not live in the United States (jargon: is not domiciled in the USA) has an estate tax risk only for assets located in the United States (jargon: U.S. situs assets). An IRA falls into this category. This means that the value of an IRA will be subjected to estate tax.

A U.S. citizen (or a noncitizen domiciled in the United States) has a large exemption from estate tax and gift tax: the first $5.43 million of wealth will not be taxed, whether it is given away during the individual’s lifetime, or left to an heir after death.

For a non-U.S. citizen who is not domiciled in the United States, the exempt amount is $60,000.

In short, if your IRA (and all of your other U.S. situs assets) exceed $60,000 in value, there will be U.S. estate tax to pay.

If you have an IRA worth more than $60,000, you would be a damn fool to leave that IRA in the United States and expose its value to estate tax. We should also not forget the cost and delay from forcing your heirs to prepare and file an estate tax return (Form 706-NA).

This factor alone should tell you to close your accounts and move the money out of the United States as soon as possible after you expatriate, even if there is an income tax or early distribution tax cost.

When and how

Now that you have decided to close your IRA, you have a question of when to do it: before or after expatriation? A few factors that you should consider:

Would taking out the IRA make me a covered expatriate under the net income tax liability test?

Is a distribution subject to the early distribution tax?

How does my country of residence see the IRA and tax a distribution from the IRA?

This is a one-at-a-time analysis. No hard and fast rules apply, but generally I suggest that covered expatriates close out their IRAs before expatriation (if they can avoid the early distribution tax) or immediately afterward (if they cannot avoid the early distribution tax).

Disclaimer

Your mileage may vary, this is not advice to you personally, everyone is a special snowflake and your life is different so get competent tax advice from someone. Look before you leap.

Thanks

Thanks to Haoshen Zhong for a lot of help this week in getting this email out. I have lots of family stuff happening this week (one kids moving up from middle school to high school, and another graduating from high school).